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Month: April 2017

Apologies for the title, but it was worth a shot. Speaking of shots, Canada has taken quite a few recently. If you’ve been on twitter and follow Marc Cohodes you know exactly what I’m talking aboot (sorry I couldn’t resist).

Before I get to the implosion in a few of the subprime Canadian Mortgage lenders, I’m going to be very honest here: Last year, I went to the John Mauldin’s investment conference and told everyone brilliant enough to listen to a man-bunned millennial how much I hated the Canadian banks and how I was short them with low delta puts. The banks proceeded to run up another +25% on me while paying 4% dividends. Needless to say, I nailed that trade…

With that said, John Mauldin’s investment conference is rolling around again, and like clockwork I once again find myself short some of the Canadian Banks which I believe are at the nexus of a number of deflationary trends.

1. Canada’s two biggest subprime lenders, EQB and HCG (DISCLOSURE: both of which I am short) are on the verge of bankruptcy threaten the very fragile Toronto Real Estate bubble.

EQB went crashing back down the 2007 highs. Likely a matter of time before it heads much lower.

HCG which plunged 60% in a single day is speculated to be guilty of fraudulent lending and is levered 15 to 1. Against this back drop, investors have been pulling money out of the bank to the tunes of hundreds of millions of dollars per week. With the bank run in full swing, HCG has been forced to borrow at an incredibly high rate of +15%. When you take into account the fact that HCG lends at 5%, it doesn’t take much intellectual prowess to come to the conclusion that the equity is worthless.

2. More importantly, the sudden collapse of Canada’s two largest subprime lenders has sent the sector in a whirlwind. Subprime borrowing rates are set to go higher. With some mortgage brokers saying as much as 20% of their mortgages go to subprime, the impact higher subprime borrowing rates have on further demand And despite what Canadians and Canadian bank bulls say, their housing market is loaded with hidden risks. Canada’s shadow banking sector per capita is actually 5x larger than China’s! Yes you heard that right.

Given the size of the shadow banking sector in Canada, it is likely that EQB and HCG are likely the tip of the iceberg of a levered financial system that has pushed real estate prices to all time highs.

3. With the most excellent of timing and in a bid to prevent housing prices from rising any further the government of Ontario instituted a similar 15% foreigner’s tax, which should put further downward pressure on real estate prices.

4. At the same time, Canada’s economy remains heavily exposed to the Chinese economy, which has likely peaked in Q1 of this year due to base effects.

“The National Bureau of Statistics’ official Purchasing Managers’ Index (PMI) fell to a six-month low of 51.2 in April from March’s near five-year high of 51.8.

Analysts polled by Reuters had predicted a reading of 51.6, the ninth straight month above the 50-point mark that separates growth from contraction on a monthly basis.

Demand weakened across the board with the biggest decline in the input price sub-index, which fell to 51.8, its slowest expansion since June last year, from 59.3 in March.”

Despite the headline, this slowdown was entirely predictable given the YoY base effects. China’s economy bottom in Q1 on the back of a the largest government stimulus since the 2008 financial crisis. Ever since last summer, the PBOC has been on mop up duty, attempting to de-lever and drain liquidity from the financial system.

One of Chinese speculator’s key vehicles of shadow banking risk, WMPs have seen their growth slow in the wake of this dramatic tightening. From Bloomberg:

“Outstanding products issued by banks stood at 29.1 trillion yuan ($4.2 trillion) as of March 31, up 18.6 percent from a year earlier, according to the China Banking Regulatory Commission. The growth rate slumped from 53 percent during the same period last year, CBRC said.”

In order for the credit cycle to continue, these Ponzi finance vehicles need to grow at an accelerative rate. This slowdown in credit growth is a warning sign that should be noted as China’s credit cycle approaches its Minsky moment.

Given M1 growth in China, it is a matter of time before the PBOC turns on the liquidity taps again, which would push the US dollar higher.

It’s important to understand the impacts a slowing Chinese economy would have on future oil demand and prices, a key component of the Canadian economy. China has surpassed the US as the number one importer of oil in the world, in large part due to massive vehicle demand and an unsustainable stimulative push. As of Q1 of this year, China’s government also ended a car subsidy, leading to a dramatic slowdown in sales. From MarketWatch:

“Growth in China’s car sales slowed sharply in March, illustrating the effects of a higher sales tax on the world’s biggest car market.

Sales of vehicles, excluding those typically used for commercial purposes, grew 1.7% to 2.1 million units in March from a year earlier, the government-backed China Association of Automobile Manufacturers said Tuesday.

This marked a slowdown from the 6.3% growth in the first two months of the year. By comparison, sales grew nearly 10% in March 2016 from the previous year.”

Inventories have risen sharply as well.

In the end, despite OPEC’s best attempts to jawbone the price of oil higher, we find the price resting at a key technical level as well as its 200dma. A breakdown in oil, would put even more pressure on Canadian banks who remain highly exposed to the sector.

Lastly, the charts of some of these banks listed on the NYSE look very weak. (Disclosure: I am short both CM and BNS on the NYSE). CM has broken below the reflation trade trend-line as well as its 200dma.

BNS chart is similar, with a familiar H&S topping pattern to boot.

Also the longer term weekly chart of BNS shows the stock failed to break at a previous resistance line.

Given these pressures on the Canadian banking system it is very likely we see a significant drop in the Loonie against the dollar. Although we should all be weary of millennial hedge fund managers bearing “obvious” trades. Cheers!

DISCLAIMER: This blog is the diary of a twenty something millennial who has never stepped foot inside a wall street bank. He has not taken an economic or business course since high school (for which he is immensely proud of) and has been long gold since 2012 (which he is not so proud of). In short his opinions and experiences make him uniquely unqualified to give advice. This blog post is NOT advice to buy or sell securities. He may have positions in the aforementioned trades/securities. He may change his opinion the instant the post is published. In short, what follows is pure fiction based loosely in the reality of the ever shifting narrative of the markets. These posts are meant for enjoyment and self reflection and nothing else. So ENJOY and REFLECT!

Additional Disclaimer: The Author is short the NYSE listed CM and BNS as well as TSX listed EQB and HCG.

TRIGGER WARNING: This post will include political analysis with very trace amounts of opinion thrown in. As investors so often like to say and rarely actually do, “I am just observing”.

“Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.” ~ Winston Churchill

The first correction in the final leg (according to me) of the post crisis bull market has begun. Given the tremendous tremendous divergence between market expectations and reality there is likely a bit more downside to come. Positioning, and sentiment are polar opposite to the bottom we saw in Q1 2016.

Especially, if you consider at what the market was pricing in: record business and consumer optimism as well as a smooth and efficient US government that would pass healthcare and tax reform in short order.

Instead we have a bellicose interventionist President Trump who has sparked geopolitical tensions in the Middle East and North Korea. At the same time, the French elections are turning out to be less clear than the market also predicted (notice a pattern).

WIDE OPEN: New French election poll puts the top four candidates within three percentage points of each other. pic.twitter.com/RsQ6HnW9Hq

In the end, shit is about to get somewhat more real, but that doesn’t mean the highs are in (more on this later). For now the Trump/reflation trades, which have looked weak these past few months are beginning to unwind. The key 2.30% technical level on the US 10 year was finally breached this week.

The technical breakdown in the US 10 year treasury likely signals further downside in US financials (XLF), a key beneficiary of the Trumpflation narrative.

The Yen a key measure of risk has been strengthening, blowing through stops, and just generally crushing risk appetite. Now below the 200dma and the 0.618 fib re-tracement level off the pre-election lows.

Semiconductors, the post Brexit leader, up 50% from the lows, has closed below its 50dma and is testing the super special (sarcasm) 79dma. But seriously. We haven’t seen a close below the 79dma since BREXIT. This will be something to watch going forward.

There’s a clear H&S pattern on the Russell 2000.

At the same time, XLE has led oil this year and looks to be headed lower. Given the importance US shale plays in the economy, this could signal further economic weakness.

Throwing salt on the open wound, retail sales and inflation both disappointed expectations on Friday.

In short: “It’s an ugly planet, a bug planet!” (Video might be broken, but hey! At least you get the reference now).

Although the risks, given the lofty valuations, are asymmetric to the downside, it is of vital importance to not get carried away with our bearishness. I made this mistake in 2016. I missed the signs of a bottom. I had been short on the way down, but instead of pulling back, I pushed harder and paid for it. Maybe this is the time to do that, but maybe it’s not (more on this later). It is worth noting that folks are still incredibly scared of a one off event (including myself).

so far 'market is gonna crash' spam email count is up to 5. how bout you guys?

As investors we are in constant conflict with our inner animal which tells us us to sell when we should buy, and buy when we should sell. Not only must we not give in to these primal instinct, we must also be keenly aware of the fact that if we are experiencing these emotions it is quite likely that others are as well.

If this correction continues it does NOT mean equities are about to fall apart. Market tops are long processes that take months if not years rarely ever days. Sure the parallels to a 1987 style event have been shown time and time again. Vol selling is the new portfolio insurance. Passive is only passive on the way up. CTAs have record assets under management. The fuel is certainly there. I get it. I am aware of it, but so is everyone else. Stocks have barely fallen and yet the cost of hedging has already shot up dramatically.

Cost of hedging against a 5% drop in S&P 500 over the next month has increased at the fastest rate since the Brexit referendum pic.twitter.com/EqyFRFuHRY

Investors remain keenly aware of any downside risk. Meanwhile the central bank put is still there. The Fed may be hiking now, but with economic data coming out towards the downside, Trump meeting stiff resistance in Congress, and most importantly a falling stock market the Fed can quickly pivot from hawkish to dovish rhetoric. If the sell off does accelerate, I expect talks of balance sheet reduction to give way to QE4.

Worth noting, as Luke Gromen likes to remind people smart enough to follow him on twitter: high stock prices are now a matter of national security. Even with equity markets at at all time highs, pensions remain tremendously underfunded. A fall in financial assets would cripple pension funds. The knock on effects would spiral out beyond the government’s control leading to consumer debt crisis with the Fed forced to monetize an ever widening US Federal Government deficit.

Thus the Fed, and “the powers at be” have a hefty amount of incentive to keep stock prices elevated. At the very least, the Fed, armed with its newly minted ammo, should be able to hold the line for 3-6 months before it has to even think of threatening the nuclear option, QE4. Look for the Fed to buy time while the market narrative adjusts to the reality.

“A growing number of forecasters are beginning to reconsider their bullish outlook for the U.S. economy as doubts grow over the extent to which President Donald Trump will be able to implement his agenda.”

Now that price and economic soft data are beginning to reflect the “hard: reality, I find it quite comforting to see economists like rats jump from the sinking ship that is Trumpflation and the hopes of fiscal stimulus that come with it. Ironically, as the mainstream lose faith in any Trump stimulus or healthcare reform, the odds of the passage of said legislation are actually rising, albeit from a very low base.

WARNING: Here be Dragons. You are entering the political analysis section of the blog post.

What the narrative surrounding Donald Trump refused to acknowledge was just how little power US presidents have domestically. This is especially true when Congress is gridlocked to a standstill. Throw in debt and demographics on top of the rigid congress, and the US president’s domestic policy is practically set in stone.

After failing domestically, Trump has turned his focus abroad. He needs to score some quick wins politically and I’d say he’s done just that. He has used missile strikes in the Middle East to threaten North Korea and force Chinese action (at least superficially).

By projecting US military strength abroad, Trump has pulled the war hawk members of Congress on both sides of the aisle closer to his point of view. At the same time, he has allowed more of his policy decisions to be influenced by Jared Kushner a left leaning New Yorker further bridging the wide divide between his administration and the Democrats.

At the same time, as the economic backdrop continues to deteriorate, Trump will be more than happy to lay the blame at the feet of a gridlocked Congress. I can see it now: “Congress can’t pass much needed health care reform while bad Obamacare implodes. Sad!”

The Democrats have the most seats in contention next year, and will need political wins to secure those seats, else they’ll cede total power to the Republicans and Trump. They can’t do that if they sit by idly as the economy implodes. With some of the Dems coming closer to Trump’s camp, it won’t be hard to leverage the necessary votes for health care reform which would then pave the way for tax reform. Throw in talks of QE4 and the stock market could surge for the final leg of the post crisis bull market.

DISCLAIMER: This blog is the diary of a twenty something hedge fund manager who has never stepped foot inside a wall street bank. He has not taken an economic or business course since high school (for which he is immensely proud of) and has been long gold since 2012 (which he is not so proud of). In short his opinions and experiences make him uniquely unqualified to give advice. This blog post is NOT advice to buy or sell securities. He may have positions in the aforementioned trades/securities. He may change his opinion the instant the post is published. In short, what follows is pure fiction based loosely in the reality of the ever shifting narrative of the markets. These posts are meant for enjoyment and self reflection and nothing else. So ENJOY and REFLECT!

This is a long article, that you’ll find to be more free flowing than previous articles (Aka I was too lazy to trim some of the fat). I don’t apologize for the length. I find writing down my thoughts to be an incredibly helpful exercise. Just like I find publishing said writings to be incredibly cathartic. With that said, this post was originally supposed to be about China, but then it eventually morphed into a more generalized view on the global economy and the major sign posts I’m looking for as the year progresses. Enjoy!

Those who follow me have probably noticed by now the hefty emphasis I put on narrative when analyzing markets. Lately, the market narrative on China has gone “surprisingly” quiet.

This silence has persisted despite a tremendous amount of action going on underneath the surface.

Like a duck on a pond, China’s legs have been churning a mile a minute. In a country where every financial asset including P2P loans comes with an implicit “government guarantee” there is not much room for restraint. Combine this false sense of security with the PBOC’s almost uncontrolled stimulus in the post crisis era, and it’s not hard to see why the central authorities in China have been so busy over the past year.

Recall that back in Q1 2016, the PBOC and Chinese government launched a massive stimulus program that forced a temporary bottom in not just China’s economy but the global economy as well. With the economy on a seemingly strong rebound, the PBOC began the process of tightening liquidity and imposing some restrictions on lenders.

Unfortunately, when a banking system is as interconnected and shadowy in nature as the Chinese banking system, this process of imposing any sort of discipline is incredibly difficult. From Caixin:

“No one in the banks knows where the money they invested in other banks’ wealth management plans ended up,” an official from the central bank told Caixin earlier. “They could not tell because the selling bank itself used the funds to buy other banks’ wealth management plans.”

So far the PBOC’s tighter monetary policy has gone on without a hitch (unless you count the December panic when a medium size brokerage firm attempted to default on its Trust Beneficiary Rights). As alluded to in the opening paragraph, this relative calm is only surface deep.

Underneath the calm waters, the risks in China’s banking system have merely shifted from one section to another, forcing the PBOC to play a game of whack-a-mole while providing just enough liquidity so that the whole system doesn’t collapse. By now, the ballooning size of Wealth Management Products and their increasing interconnectivity is well known as well known as what they are actually invested in is unknown.

“Along with the surge in the issuance of CDs, more than 15% of bank wealth management products were held by other banks as of June 2016, up from less than 4% at the beginning of 2015, an increase of 3.5 trillion yuan over a period of just 18 months, according to the report.”

What has been less talked about is the burgeoning role that interbank certificate deposits are playing in the Chinese banking system.

“In the first two weeks of March, the issuance of interbank negotiable certificates of deposit (CDs) exceeded 1 trillion yuan ($145 billion), following a record net increase of almost the same amount in February, according to data from Wind Information, a financial data provider. The issuance of CDs in January and February was 990 billion yuan and 1.97 trillion yuan respectively.

One possible reason for the explosion in CD issuance in recent months could be the dramatic increase in rates. Rising from 2.8% last August to 4.77% in March. Banks may be trying to lock in the cost of funding before it rises any further.

The interest rates that banks needed to offer to get funds through the CDs have increased as well, reaching an average of nearly 4.77% on March 22 for a three-month contract. In late August, when the central bank started raising money costs through open market operations by tightening the supply of short-term, cheaper funds, the rate was only about 2.8%.”

At the same time, about 48% of CDs are set to expire by the end of the Q2, further driving demand. Of course, these products will all be rolled over at much higher costs, hurting bank profitability. From Natixis Research:

To make matters worse, the rising risk associated with interbank CDs is concentrated in the smaller less well capitalized banks. From Caixin (my emphasis in bold):

“Small and midsize banks have been the primary issuers of interbank CDs. According to a research report from Haitong Securities, nearly 90% of the 7.4 trillion yuan worth of outstanding CDs as of March were issued by the national joint-stock banks and city commercial banks.“

Just how poorly capitalized are these banks? From Caixin (my emphasis in bold):

“A simplified way to measure the leverage, as provided by the report, shows that, on average, the total assets of depository financial institutions in China (excluding the central bank) have grown to almost 50 times their net capital. The ratio for some midsize banks, which rely more on interbank loans, has reached 60. In 2007, the average ratio was just about 30.”

So what does this all mean? It seems that the PBOC’s runway to tighten liquidity in the interbank market will be significantly limited going forward. The fact that the PBOC has been able to tighten as much it has without incident is more illustrative of the incredible amount of excess liquidity in the system than its resiliency. Arguably no sector in China has benefited from these high levels of excess liquidity than real estate.

Despite house prices rising at their fastest rate in 7 years, profitability among developers has declined.

Falling profits and rising leverage against a falling liquidity backdrop is not exactly the ideal mix for a speculative bubble. But if you ask members of the PBOC, they don’t seem very worried at the moment. Apparently they’ve solved that seemingly “impossible trinity” problem.

“Chinese central bankers have done the economic “impossible”, finding a way to have a ­stable yuan, a free market and effective monetary policy.

That is the assessment of two central bank researchers, who claimed in a paper published on the People’s Bank of China’s website on Thursday that Beijing would continue to realize the “impossible trinity”.”

How does that saying go? Something something pride before the fall? This is almost as bad as the Latvian central banker claiming to be a “magic person”. To be clear Latvia hasn’t found itself in a heap of trouble, and the PBOC’s alleged conquering of the impossible trinity is not exactly an indicator of anything other than central banking hubris which let’s face it is always turned up to 11.

“I also see incredible potential for the PBOC to defend the psychologically important $3T reserve level this month. Come the release in early February, the market may be shocked to discover that the $3T reserve level has held. The Yuan could strengthen and the narrative would temporarily shift to the masterful job done by the Chinese Authorities, and developed markets would rally on the back of higher inflation.“

My oh my how the narrative shifts. Of course, China has not solved any of its problems. If anything they have grown larger, which has forced the authorities to take drastic actions. Like preventing foreign companies from taking their profits out of the country.

These stricter measures on top of a false sense of currency stability has emboldened Chinese corporates to ramp up their offshore dollar borrowing again. From the WSJ:

“Chinese firms have issued some $52.6 billion worth of U.S. dollar bonds in the first quarter, up 72% from the previous three months, according to Dealogic, and nearly five times the amount from the first quarter of 2016.”

One of the corporations borrowing dollars in the offshore market is one of the most indebted domestic property developers, Evergrande Group.

The purpose of this money is to “refinance existing debt”, because what else can Evergrande do? If Evergrande can’t get profits offshore (if it even has any) how on earth is it going to pay back this debt, unless it borrows even more dollars. From the WSJ (my emphasis in bold):

“In mid-March, one of China’s largest and most indebted property developers, China Evergrande Group, priced three dollar bonds in Hong Kong within a week for a total of $2.5 billion, which the company says it will use to refinance existing debt.”

All it takes is for a little stability in China and everyone loses their minds. But Chinese corporates aren’t the only ones throwing caution to the wind. As pointed out numerous times on Twitter by Darth Macro, investors are increasing their exposure to Emerging Markets, despite deteriorating macroeconomic fundamentals.

I think you get the point. Investors have looked around, and found the coast to be clear. Which is why I put an emphasis on the subsurface activity in China. Important to note that it is not just in China where the subsurface activity betrays the market narrative. Any China and EM related story would be unfinished if I did not touch on the US dollar, where once again we find the narrative to be in opposition to the underlying fundamentals. The following is a headline from the WSJ:

“Dollars shortages are now going away, helped by expectations that U.S. regulation will be relaxed, the success of overseas banks in finding alternative sources of finance and greater appetite from investors to pick up what looks like free money left lying around by the global financial system.”

“In 2013, the same sentiments were expressed only with QE3 in mind rather than regulations. It was only after the events of later 2014 forward completely and utterly surprised these mainstream opinions that it was after-the-fact decided regulations just had to be to blame. Even if we assume that was and is the case, the relative comparison of swap spreads (or UST yields, eurodollar futures, etc.) then versus now shows a very different interpretation than a return of dollar flow. Markets were much more excited and indicative of a that four years ago versus now, and given that turned out to be a false assertion, what does that say about the same one being prepared all over again?

For one, it was the 30-year swap spread that turned positive if only briefly in the summer of 2013. Almost four years later, the 30s have like the 10s improved but only in comparison to last year; they are still highly negative.”

In spite of this shortage of dollars, the Fed in all of its “wisdom”, has decided that now is the time to take away the punchbowl. After two back to back rate hikes the Fed has quickly moved on to balance sheet reduction.

The hawkish shift from the Fed in light of the subsurface problems in China is either hilarious or astounding depending on your disposition (I myself am half astounded half cracked up). Curiously enough, the most recent FOMC minutes tell a different story (my emphasis in bold).

Clearly they are worried about something, or as the quote suggests… pretty much everything. If high yield corporate bonds, commercial real estate and equity prices are all overvalued then there isn’t much room for anything else.

Investors are increasingly paying a premium for junk bonds that could be called at lower prices. More signs of froth https://t.co/jh2osiJCAV

And this could just be the beginning of the bursting of a large multi-decade bubble in American retail stores. Retail square feet per capita in the US is 6x more than that of Europe or Japan. For all the grief Americans give China over its real estate boom, we have one of our own.

I know I’ve gone all over the map right now, so here I’ll try and wrangle some of these ideas back in. China’s economy although swimming in excess liquidity is going to face some headwinds towards the end of the year. Dollar liquidity although better than last year, is nowhere near a level to justify a hawkish Fed. US economic data, is nowhere near the level to justify a hawkish Fed. So why is the Fed hiking? An even better question might be: how have financial conditions been easing in the face of the hawkish Fed?

In this world of passive investing and ZIRP and NIRP, traders and now larger and larger asset managers are just looking for any excuse to sell vol. Every single time the VIX spikes above 13, it is immediately sold. This prevents equities from correcting and leads to a build up of risks in the system.

This is rampant selling of vol will lead to a whirlwind of unintended consequences, because it creates a false sense of security at the Federal Reserve. Historically the only thing that has stopped the Fed from hiking is a falling stock market. The Fed never responds to economic data, or dollar liquidity issues or anything of that sort. It only responds to falling stock prices. And if stock prices are being artificially propped up due to this “rampant selling of vol” then the Fed will keep on hiking or said differently vol sellers have numbed the Fed to its own hawkish policy!

It is quite likely given the rampant vol selling that the Fed has already tightened too much. Especially if you use the Wu-Xia shadow fed funds rate.

With that in mind, I think the odds of the stock market going considerably higher are quite limited. I’ve expressed my bearish views on the stock market for the past few months in a number of posts and believe my position has continued to be supported by the economic data as well as the capital flows. Dumb money in.

I underestimated Vanguard's Q1 haul. They actually took in $121b, which is $2b/day, and 46% better than any other Q1, on pace for $480b.. https://t.co/P8oHgZaP5Z

Now I don’t have a crystal ball, so I don’t know if stocks go up or down over the rest of the year. I’m just saying the odds that stocks continue to rise is falling at a rapid rate. But if stocks continue to rise, we should expect the Fed’s hawkish rhetoric to continue DESPITE any deterioration of economic data. When the next correction does come, I suspect any talk of “balance sheet reduction” will be dropped faster than Romulan Red Matter (although technically it was created by the Vulcans?).

DISCLAIMER: This blog is the diary of a twenty something millennial who has never stepped foot inside a wall street bank. He has not taken an economic or business course since high school (for which he is immensely proud of) and has been long gold since 2012 (which he is not so proud of). In short his opinions and experiences make him uniquely unqualified to give advice. This blog post is NOT advice to buy or sell securities. He may have positions in the aforementioned trades/securities. He may change his opinion the instant the post is published. In short, what follows is pure fiction based loosely in the reality of the ever shifting narrative of the markets. These posts are meant for enjoyment and self reflection and nothing else. So ENJOY and REFLECT!